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The term NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment. It is a concept in economic theory significant in the interplay of macroeconomics and microeconomics. This "full employment" unemployment rate is sometimes termed the "natural rate of unemployment" or the "inflation-threshold unemployment rate": if actual unemployment falls below the NAIRU, the inflation rate is likely to rise quickly (accelerate). In terms of output, the NAIRU corresponds to potential output, the highest level of real gross domestic product that can be sustained at any one time. This is also called the "natural gross domestic product."
The concept arose in the wake of the popularity of the Phillips curve which summarized the observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for a number of industrialised countries with more or less mixed economies. This correlation (previously seen for the U.S. by Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a point on the trade-off between unemployment and inflation which matched a domestic social consensus.
During the 1970s in the United States and several other industrialized countries, Phillips curve analysis became less popular, because inflation rose at the same time that unemployment rose. (See stagflation.) Worse as far as many economists were concerned, the Phillips curve had little or no theoretical basis. Critics of this analysis (such as Milton Friedman and Edmund Phelps) argued that the Phillips curve could not be a fundamental characteristic of economic general equilibrium because it showed a correlation between a real economic variable (the unemployment rate) and a nominal economic variable (the inflation rate). Their counter-analysis was that government macroeconomic policy (primarily monetary policy) was being driven by a low unemployment target and that this caused expectations of inflation to change, so that steadily accelerating inflation rather than reduced unemployment was the result. The resulting prescription was that government economic policy (or at least monetary policy) should not be influenced by any level of unemployment below a critical level - the "natural rate" or NAIRU.
If U* is the NAIRU and U is the actual unemployment rate, the theory says that:
- if U < U* for a few years, inflationary expectations rise, so that the inflation rate tends to accelerate;
- if U > U* for a few years, inflationary expectations fall, so that the inflation rate tends to slow (there is disinflation); and
- if U = U*, the inflation rate tends to stay the same, unless there is an exogenous shock.
Most economists do not see the NAIRU theory as explaining all inflation. Instead, it is possible to move along a short run Phillips Curve (even though the NAIRU theory says that this curve shifts in the longer run) so that unemployment can rise or fall due to changes in inflation. Exogenous supply-shock inflation is also possible, as with the "energy crises" of the 1970s.
The NAIRU theory mainly intended as an argument against active Keynesian demand management and in favor of free markets (at least on the macroeconomic level). There is for instance no theoretical basis for predicting the NAIRU. Monetarists instead support the generalized assertion that the correct approach to unemployment is through microeconomic measures (to lower the NAIRU whatever its exact level), rather than macroeconomic activity based on an estimate of the NAIRU in relation to the actual level of unemployment. Monetary policy should aim instead at stabilizing the inflation rate, perhaps at zero.
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